U.S. Structured Credit Roundtable: To Securitize Alternative-Energy Projects Successfully, Government Support May Be Needed

1. U.S. Structured Credit Roundtable:
To Securitize Alternative-Energy
Projects Successfully, Government
Support May Be Needed
Primary Credit Analysts:
Weili Chen, New York (1) 212-438-6587; weili_chen@standardandpoors.com
John Lampasona, New York (1) (212) 438-3619; john_lampasona@standardandpoors.com
Business Leader - U.S. Structured Credit:
Peter Kambeseles, New York (1) 212-438-1168; peter_kambeseles@standardandpoors.com
Analytical Manager - U.S. Structured Credit New Issuance:
Winston Chang, New York (1) 212-438-8123; winston_chang@standardandpoors.com
Analytical Manager - U.S. Structured Credit Surveillance:
Stephen Anderberg, New York (1) 212-438-8991; stephen_anderberg@standardandpoors.com
Table Of Contents
Panel Discussion
February 16, 2010
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2. U.S. Structured Credit Roundtable: To
Securitize Alternative-Energy Projects
Successfully, Government Support May Be
Needed
Governments, investors, and ordinary citizens alike are increasingly concerned with the implications of what nearly
all scientists now agree is man-made climate change. We believe the potential threats to economic and social
well-being from increased greenhouse gas emissions, changing weather patterns, growing global energy needs, and
rapid industrialization in some emerging markets demonstrate the need for significant funding to resolve these
problems.
In Standard & Poor's Ratings Services' view, securitization is emerging as a tool to raise the billions of dollars
needed to fund solar and wind generation, for instance, or to back carbon credit trading. But because many "green"
initiatives are relatively new and untested, investors may gain confidence from government support at the state,
regional, federal, and perhaps even the supranational levels. That support can be financial. It may take the form of
more transparent and stable legal and regulatory structures.
The roundtable was moderated by credit analyst Weili Chen, a director in Standard & Poor's Structured Credit
group. Participants included: Ronald S. Borod, Partner, DLA Piper; John Dolan, Consultant, Second Order
Strategies Inc.; John Joshi, Managing Principal and Business Strategist, CapitalFusion Partners; Thomas R.
Weinberger, Partner, Stroock & Stroock & Lavan LLP. What follows is an edited excerpt of the conversation.
Panel Discussion
Weili Chen: What are some of the current issues in the alternative-energy sector?
Ron Borod: One question is whether the capital markets can repair themselves in time to fill the huge financing void
that's there. The European Wind Energy Association had estimated that, as of 2005 there was about $626 billion of
new investment expected if they were going to meet their goal of 12% of all energy being wind produced--and that's
just the wind sector. The problem was that the capital markets couldn't compete with the rates that the banks were
offering. Well, obviously, the scene has changed.
John Dolan: There is also a big question as to whether the concept of cap-and-trade can be embraced by the
American public. There are some who would prefer to see a carbon tax (or "fee") to give price stability, and the
debate between cap-and-trade and tax advocates is likely to continue into the future.
Tom Weinberger: My area of expertise is the securitization of insurance risk, and the alternative-energy space is very
interesting for insurers generally. Insurers are very concerned with climate change and how it will affect their
business. The insurance industry has probably been at the forefront of monitoring climate change and how it will
affect their business management. Because of that, they have expressed a significant amount of interest in investing
in alternative-energy products. There are a lot of technologies that have been developed in terms of insurance risk
securitization that can be leveraged and used in the alternative energy space.
We discussed just now the investment dollars flowing into alternative energy. From an insurance company
perspective, if there could be rated bonds related to alternative energy, that's a much easier investment vehicle for
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3. them and a much easier investment decision. So that's where they would like to see the dollars.
To give just one example, there was a reforestation bond done a number of years ago in Panama. It was more of a
climate change product than an alternative-energy transaction, but it is illustrative. Along the Panama Canal, the
forests were pretty much denuded and there was a lot of silt building up in the Panama Canal, which caused a lot of
trouble for the insurers because they were the ones that wound up paying to have the canal dredged. The insurers
participated in developing a reforestation bond, which was sold to insurance companies, as well as people that used
the canal. That money was used to reforest, which is going to generate significant savings on insurance costs as well
as costs for insurers.
Congress is actively considering a number of alternatives. So there's going to be a lot of pressure to do something
and the alternative-energy space is going to be a leading space in how we address these issues.
Now it may not be cap-and-trade, it may be cap-and-tax, or it may be cap-and-dividend but there is a drive to look
at new technology, finance those new technologies, and, to the extent that we can, make a capital markets product
that will just further help develop this space. This will speed the recovery development and build-out.
Weili Chen: Are there any regulatory drivers now at the state, regional, or federal level that may be
relevant?
Tom Weinberger: If we're talking about carbon credit trading, there are mechanisms that are developing on a
regional and state level. The question is, if we don't have a national cap-and-trade plan, will any of these markets
really develop in the U.S.?
Ron Borod: I would concede the point only if the credits are fungible across state lines. There has to be linkage. I
can see it happening on a state level if there is linkage, but if there's not--if each state is going to have different
standards, different credits that are not tradable across state lines then—well, that's something that's going to be
hard.
John Dolan: We also have to overlay the issues of state versus federal government control here. The carbon
reduction efforts on the two coasts (Regional Greenhouse Gas Initiative and Western Climate Initiative) continue to
expand their programs and dictate standardization of terms. The federal government will be presented with a fait
accompli, will face a more difficult time setting policy, and may miss out on their potential share of the revenue
from auctions of carbon credits.
Ron Borod: The whole purpose of cap-and-trade is to create a market-driven system. So you need to make sure that
the markets are going to react to it favorably and actually use it. And what we're also about here is to create
liquidity in that market if that market is developed. I think if you don't have federal preemption then it's going to be
very difficult to create standardization and to create liquidity that would result from that.
Weili Chen: What is the impact of the current macroeconomic environment--the price of oil, the condition
of credit markets, and the general shape of the economy?
John Dolan: A direct effect of these price declines has been a reduced incentive to innovate to find alternative-energy
sources, and to think of creative alternative energy financing. Washington has become the center of not only the
financial issues, but also all environmental and energy-related issues.
That's an important change because investors, borrowers, and investment bankers can't make long-term financial
decisions without more certainty from the government. Will we have a cap-and-trade program or will there be a
carbon tax (or fee)? Will investment credits for new technology like wind be rolled over year after year, or be left to
Congressional vote every two years? What will be the framework for tax policy and budgets? So I think those are
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4. just some of an endless list of consequences as a result of today's economic issues.
Ron Borod: The DOE [Department of Energy] loan guarantee program for renewable energy projects is putting
some huge amounts of dollars--they haven't hit the system yet--but we know--we have clients who are applying for
those guarantees and it's going to be a major stimulus for the renewable sector, solar in particular but also other
forms.
At the same time, the economic decline has resulted in a lot of the tax equity providers not having any tax exposure
and therefore not needing to buy the tax equity position that a lot of these projects have relied heavily upon. So the
tax benefits that have become part of the mechanism for financing renewable energy projects are not being bought
because no one needs them.
And as John said, the fact is that the price of energy is declining. Carbon pricing has declined because of the
economic decline and that's put a lot of people into sort of this fool's paradise, if you will, that oil prices are cheap.
So why do we need to go to alternative energy?
John Joshi: I think one of the challenges that we need to look at is that when we did the stimulus package here in the
U.S. I think they allocated probably about $10 billion or $12 billion overall within the DOE program. And I think
some of that got used for the Cash for Clunkers, if I'm not mistaken.
John Dolan: To the extent that many of these assets and financings in the alternative-energy world, such as wind,
solar, or nuclear, are very long term in nature (and are of unproven technology, and where spot energy prices are
very volatile), borrowers are going to need some extremely high-quality counterparties agreeing to formulaic prices
well into the future, to arrange long-term financings. Will the debt markets, and the rating agencies, trust that these
take-or-pay contract counterparties have truly 'AAA' credit risk for the life of these projects?
Separately, there's also going to be a need for some very long-term and consistent government policies toward those
projects, for investors and rating agencies to get comfortable in the viability of their projected cash flows. It's hard
enough to make projections on oil and carbon prices in a stable policy environment, but how can you plan on
long-term financial commitments to extract oil or sequestering carbon if the government changes tax and subsidy
policies with every Congress?
John Joshi: You almost need a quasi-government type of entity. You need a liquidity conduit that can be almost an
insurance. And obviously we can't turn to the mono lines; we can't turn to any of the other traditional structures.
Weili Chen: What, in your view, would it take to develop alternative-energy securitizations, given the
economic, technological, environmental, and participation uncertainties?
Ron Borod: In the Breeze 1 deal, all of the counterparties in the off-take agreements, in that portfolio of wind farms,
were unrated. But the rating agency took comfort from the fact that even if one of the off-takers should go into
insolvency because of the regulatory regime that existed in Germany, where most of those were situated, someone
had to move into the slot.
In other words, you had to find another off-taker to move in and buy that power. So another alternative to having a
governmental support for the counterparty risk is to have a regulatory scheme that requires that there be buyers.
Tom Weinberger: I believe that in many of the Breeze transactions, the securitization was actually take-out
financing, in that there were very few undeveloped projects in those portfolios. You had 70% that were already
operating. You had an operating history there. It would be much more difficult to take a portfolio of undeveloped
wind farms with an unknown history and try and rate that.
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5. I do think it's a challenge however to do them for undeveloped projects or projects on the drawing table. I think
solar--and I do believe that actually some of the wind farm securitization deals done in Europe did have some small
solar components in there--is very hard because wind technology is relatively well known, but the solar technology is
still under development. I think that poses significant challenges.
John Joshi: Because of the nature of wind farms, there is no tangible hard asset, other than the equipment, that you
can perfect interest in. It is all future flow structures to start with. So you could have a structure which has some
part of development construction process and then it settles into a permanent vehicle, but it obviously is a managed
structure. I think from a policy point of view, feed-in tariff has shown to be how investors in projects get
comfortable because they're doing a look-through to the actual off-taker who's providing the long-term guarantee
on it.
Tom Weinberger: I just want to add that here are a few other elements that you have to get very comfortable with.
One, you have to get comfortable with the wind data that's available and how it correlates with what may be
produced. Wind ebbs and flows over time, so it is difficult to always measure it properly. And if your measuring
station is not in the right spot you're going to get different reads than when you actually put up the wind turbine.
You have servicing issues and operational issues that pose challenges as well. If you are dealing with a new project,
and you have an operator that doesn't have a long history, there will be concerns about the ability of the operator to
manage the project properly, and this will be reflected in the rating.
The larger wind farm operators have better access to turbines and to get replacement parts. If you're a smaller
manufacturer, and something breaks, you may have to wait a while to get a replacement part because the market is
not necessarily up to speed.
So those are all challenges from a rating perspective and a securitization perspective that have to be considered.
Ron Borod: I agree that there are a lot of challenges like that. On the wind variability challenge, even if you had a
long-dated off-take agreement, the buyer is only buying the energy that you produce. So wind variability undermines
that regime. What has happened in the deals that have been rated, obviously, is that non-correlated wind sites have
been selected that historically have had different wind patterns so that one, hopefully, offsets the other in a portfolio
effect. But over the long haul, I think they would be protected just because of the historical trends.
Tom Weinberger: There has been preliminary work done. The challenge so far has been getting the pricing to a
point where it makes sense for all the parties. But conceptually, yes, there is a product to be developed and there are
insurers that are very interested in providing that kind of coverage, which, if combined with a feed-in tariff system
and loan guarantees from governmental sponsors, would make a highly rated securitization that much more viable.
John Dolan: There also seem to be some parallels with the subprime world. The insurance industry, as Tom
suggested, has exposure to weather. And these products that we're talking about are impacted by weather. So it
makes sense to me that there should be some concentrated industry effort to develop more vibrant weather-related
derivative markets so that people are more comfortable in their ability to hedge the impact of changes in the weather
going forward.
Weili Chen: What are the unique legal issues that arise from this asset class or these sectors in the context
of securitization, not limiting to security interest and some of the other regulatory-driven issues?
Ron Borod: What's different about these deals is that we're talking about future flow transactions. These are not
transactions where you put financial assets into an SPE [special-purpose entity] and wind them up and let them run.
Alternative energy is all about future flow. There are all kinds of embedded operational risks. I agree with Tom that
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6. the quality of the operator is the key. I think the structure that these deals are going to have to take legally is going
to look a lot like some of the operating company securitizations whereby you would have an SPE that would issue
the actual securities.
You would probably have a separate SPE that would hold the operating assets. And then you would probably have
an operating company that would be responsible for the operations just to try to isolate the various risks from the
issuer of the securities. And these would probably be in a parent/sub relationship. So I think that is probably the
way a lot of the structures would look.
John Dolan: There are some important lessons to be learned from the problems of last few years that could be
applied in these structures, if they don't already exist. One is the idea of including an independent credit risk
manager who is charged with representing interests of the note holders as credit situations arise. Importantly, this
entity should not be related to the borrower, the servicers, or the trustee of the deal, to avoid even the appearance of
possible conflict. Keeping structures simple, and/or having an independent credit risk manager, will make it easier to
raise funds from investors looking to buy bonds, not loans.
John Joshi: And then you have utility scale structures whether you have diversified solar, wind, geothermal all
lumped together in order to give more diversity and less overall correlation. We know about wind volatility, but at
the other side of the spectrum is solar. Solar radiance has a much tighter volatility structure.
You know, I think S&P, in fact, put out some details on that also. And beyond that, if you're looking at future flow
receivable structures there are aspects of offsets or carbon credits. What is a carbon credit? Is it a right to pollute? Is
it a permit? Is it a tangible--how do you get delivery of this credit, in case you had to unwind the deal? How do you
not have duplication issues? There are a lot of regulatory issues that need to be addressed on that side in terms of
perfecting an interest in the carbon credits. There are some legislative issues that came out of the Netherlands on
carbon credits, what you can and can't do with that in terms of perfecting interest.
It's a very broad issue and I think some of the earlier projects will probably borrow methodology from CMBS
large-loan structuring, or CLO, or a combination of that. I think if you marry that to leasing structures, if you put
that together, those are the kinds of structures that have well-defined methodologies in place.
Ron Borod: We haven't talked about securitizing carbon, but the unique problem is that it's not even a future flow
asset. It's simply a commodity. And if you're looking for any analogs, if one were trying to securitize a carbon
portfolio, the analogs would be timber and crude oil and some of those other commodity deals.
So, in the case of carbon, it seems like you would have to have an actively managed portfolio. It would almost be
like a CDO with an asset manager, who would be under restrictions as to when he has to sell, and when he has to
buy. There would be sort of some kind of a program trading aspect that would have to be factored into the
documents, to make sure that cash flow is generated off of the credits, at the appropriate times, in order to meet
debt service requirements.
Weili Chen: What are some of the trends regarding alternative energy and carbon finance internationally,
and how do they compare to those in the U.S.?
Ron Borod: Well, it's interesting that most of the precedents that we've talked about are actually from Europe. But
the reason those deals happened was because they had feed-in tariff regimes that made a huge difference in the
reliability of the cash flows.
But that is not present here, and therefore we are not going to be able to get as robust a market started without it, or
something like it, in the U.S.. There's a little bit of a movement in Florida, although I don't think it's going anywhere
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7. in this legislative session.
What's really driving a lot of this globally has been government intervention, government policy, which has worked,
and which has been very market friendly. Even in the case of the EU's ETS [Emission Trading Scheme], I have met
with people in London in government who were very serious about making sure that the next chapter beyond Kyoto
is going to be market friendly. I think the U.S., when it gets serious about it, just has to do the same thing. We have
to really understand the markets and adopt regimes that will play into an efficient market.
John Dolan: I was only going to add a glib comment that there seems to be a "not invented here" syndrome in the
U.S. when thinking about securitization concepts. Too many people think that we'll apply our domestic solutions to
our problems, and that there's nothing to learn from looking abroad. We have to recognize and acknowledge that
Europe is way ahead of the U.S. in terms of alternative energy and that there's a lot to be learned from how they've
gone about it. This industry needs to continue to educate investors, regulators, and bankers as to how other
countries have dealt with alternative-energy financing.
John Joshi: I would like to see more of a quasi-government and private enterprise approach, or a series of
discussions going on within the government and the private sector in addressing these issues. I don't see any
developments in that side other than strict conversations that are happening on the DOE side that needs program
implementation. But we need far more, a strategic initiative between private and public partnerships similar to what
we've done for traditional assets. Hopefully, that will open up a lot of opportunities to really create products that
are really beneficial overall from our perspective. Securitization gives that opportunity where traditionally these
assets were done on a project finance basis, and you had people who were experts or engineers.
Weili Chen: Looking to the future, what opportunities and challenge do you see in this sector, particularly
as they relate to securitization?
Tom Weinberger: The opportunities are tremendous because I think the U.S. at this point is at a crossroad in our
energy production and distribution. We are migrating from old coal-based technologies, which still will be around
for a long time, to newer technologies.
We have to upgrade the grid to handle this newer technology. For example, one of the challenges with wind farms
and solar is that the power is intermittent. So they have to transfer it when it's produced and they have to deal with
the peak times versus non-peak times.
The challenges are going to be principally in moving beyond a patchwork of state-based incentives and regulations
to a more national and perhaps even global framework for dealing with alternative energy and how we're going to
trade this because this is really a global issue, it's not a western state issue or an eastern state issue. It's global.
John Dolan: I think there's going to be three building blocks to move forward on alternative-energy financing. One
is the importance of education of all market participants. We need an ongoing education program here to make sure
that those structuring, rating, and investing in these alternative energy financings actually know the mechanics and
risks in the underlying sectors. The GARP Energy Risk Professional exam is a great example.
Second, global warming and carbon emissions are issues which will require solutions from around the world. As an
industry, we will need to be more open-minded on alternative forms of energy, such as nuclear, forms of energy
pricing, and alternative approaches to securitization.
Third, I think that there are lessons to be learned from the subprime/CDO problems of last six or seven years, which
we have the opportunity to correct here. The first is that the industry--including the rating agencies--should embrace
a more "open book" approach to the modeling assumptions. The second is the point I mentioned before about
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8. having learned the importance of having an independent credit manager named as part of the deal, to represent
investors, and avoid the appearance of conflict.
Ron Borod: There is one government program and a lot of things have been tried over the last year to try to get the
[securitization] markets back. And in my view, a lot of them are badly conceived and badly executed. It'll be
interesting to see how this all plays out. But some things could be a stabilizing and neutral force.
A recent TALF deal that has been priced went very well, even though only 22% of the 'AAA' buyers use TALF.
What that tells me is that the market is kind of looking for something like what John Dolan suggested, and that it
may be even more important in the renewable space where there's so much very difficult and complex underlying
technology. Having a TALF-like program, and I'm not saying the Federal Reserve Bank in New York should be the
one running it--it probably shouldn't be--would provide that additional layer of comfort and provide some leverage
for the 'AAA' buyers could be very useful here.
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